Wednesday, June 3, 2015

An Improved High Yield Alternative

I really don't like the high yield asset class. Not just in the current environment with near-low historical yields and the potential for material liquidity issues, but in general. As an asset class, I think high yield:

  1. Often caters to unsophisticated investors that only look at the yield
  2. Is riskier than its returns suggest due to an opaque credit market that doesn't as regularly reprice bonds (as they do within equities)
  3. Has unfavorable tax consequences relative to stocks as coupons are taxed at a much higher rate than the capital appreciation of stocks

Historical Performance Comparison to Stocks

One draw of high yield is the view that its performance is from a known yield (vs. the less guaranteed market appreciation of equities). In addition, the Sharpe ratio of the asset class has historically been superior to stocks (i.e. more return per unit of risk). The counter points to that argument is that the Sharpe ratio is overstated as volatility of high yield is under-reported (see point 2 above), as well as the fact that high yield returns are the result of two factors (credit and rates) that can be replicated with an allocation to stocks and bonds (thus a high yield vs. stocks comparison is apples to oranges). Case in point being that a 54% S&P 500 / 46% treasury portfolio since the Barclays High Yield 1983 inception has the same standard deviation and higher returns vs high yield... thus a higher Sharpe ratio. 

Decomposing High Yield Returns

Before getting into details of a high yield alternative, let's decompose historical high yield returns to get a better sense of what an investment in high yield actually provides. 

High yield benefits from the return of two main factors, credit and rates (actually as we'll see it mainly benefits from rates). As the chart outlines below, the credit (spread) component of high yield and the rates component are often well balanced, making high yield a "risk-parity" like allocation between the two factors. As a result, comparing high yield to a blended stock/bond allocation rather than a stand-alone stock or bond allocation makes sense. Or as we'll outline below, there may be an opportunity to replace one of the factors with a more efficient / more liquid component. The below charts break down the returns into these two factors over the past 25 years (as far back as Barclays reports them separately).

Despite a higher contribution to portfolio level risk from the credit (spread) component...

Credit (spread) has provided a materially smaller contribution to the long-term performance of high yield

Swapping in Credit Risk via Equities vs. Bonds

If high yield is a sub-optimal way to access credit risk an investor utilizing leverage can replicate high yield via treasuries for the rate factor and the S&P 500 for the credit / spread factor.

The below chart shows the equity curve of two such options going back to 1983...
  • High Yield Alternative A: scale stocks to provide similar return as high yield: 100% treasuries, 24% S&P 500 financed at 3-month t-bills 
  • High Yield Alternative B: scale stocks to provide similar risk as high yield: 100% treasuries, 46% S&P 500 financed at 3-month t-bills

The Results

Historical results are certainly promising on an absolute and relative basis. Not only were Sharpe ratios improved, drawdowns were materially reduced. In addition, a portfolio consisting of treasuries and the S&P 500 will likely be MUCH more liquid than high yield during periods of turmoil.

Sources: S&P, Barclays, Federal Reserve